June marked another positive month for equity markets, with emerging markets (EM) outperforming their developed market counterparts. U.S. equities improved slightly for the month after a strong start to the year, but the MSCI EAFE Index fell modestly despite currency serving as a tailwind in aggregate. The decline in U.K. equities fueled weakness as the potential departure from loose monetary policy weighed on the market. The U.S. dollar (USD) continued to decline against its developed market peers and the Dollar Spot Index posted its worst quarterly result since the 8.5% decline in 2010.
Despite a softening outlook for U.S. inflation and growing acknowledgement that further unemployment improvements will be difficult, markets increasingly believe the Fed will not alter its path to policy normalization. Meanwhile, the macroeconomic outlook in Europe continued to improve and the tone among many major developed market central banks was more hawkish, suggesting a greater chance for monetary policy convergence among central banks going forward. Elsewhere, sovereign yields generally moved higher, but bond indices were flat to modestly down and the interest-rate-sensitive REIT market still posted strong gains—led by U.S. REITs (+2.6%).
The dollar’s weakness relative to developed market peers benefited non-U.S. developed market equities. The Dollar Spot Index fell 1.4% in June and 6.4% year-to-date (YTD). Of the six underlying constituents, only the Japanese yen (−1.6%) declined versus the USD for the month. Central bank policy divergence appeared to no longer contribute to dollar strength. In addition, the prospect for fiscal stimulus in the U.S.—a factor that has supported the dollar—is now uncertain. The health care package passed by the House faces difficulties in the Senate. With tax reform a major component of each chamber’s bills, the probability of repealing and replacing Obamacare along with enacting tax reform is shrinking. Furthermore, with fiscal deficits already on the rise due to declining tax receipts and a preponderance of deficit hawks in Congress, the chances for increased infrastructure spending remains uncertain as well. Following a challenging first six months, the Trump administration may also lack the political capital to implement a number of campaign promises.
While all developed market currencies appreciated against the USD with the exception of the yen, there was notable divergence among EM currencies. Out of 30 EM currencies that are neither pegged to the dollar or tightly managed by a central bank, 15 appreciated against the greenback and 15 depreciated. Commodity prices were mixed, with gains in agriculture and industrial metals but declines in energy, precious metals, and livestock. This may have impacted countries like Chile (+1.0%) and Russia (−4.2%), but the degree of divergence suggests idiosyncratic forces may have played a bigger role in separating winners from losers. For example, the 3.3% rise in the Mexican peso may have been influenced by both receding concerns about the U.S. administration’s stance on immigration and by an active central bank that is focused on supporting the currency. Given their roles in the European supply chain, central and eastern European countries have likely traded higher in sympathy with the euro on better economic data. Lastly, Brazil’s weakness may have been caused by ongoing macro and political uncertainty. Unlike developed markets, the impact from EM currencies on risk assets was mixed.
Technology stocks modestly retreated in June after a strong start to the year through May. Despite a decline of 2.7% in June, the S&P 500 information technology sector’s 17.2% YTD rise remained at the top among the 11 GICS sectors. Following considerable YTD gains through May for Apple (+32%), Facebook (+32%), Alphabet (+25%), and Microsoft (+12%), each posted losses during June. These four positions represent more than 40% of the technology benchmark and highlighted how a handful of names could drive performance going forward. Data from Bank of America showed the overweight to technology by active managers was at a record high in June. While broader investment sentiment has reflected strong growth prospects across the sector, a rotation out of key index constituents due to concerns such as profit-taking or valuations could be a potential headwind. Technology is currently the largest component of the S&P 500 Index and is well above the mid-teens weights for financials and health care. Apple, Alphabet, and Microsoft are the three largest weights in the broad benchmark, with Facebook currently sixth.
Outside of the U.S, a U.K. election again dominated headlines and surprised the markets just one year removed from the Brexit vote. Prime Minister Theresa May called for snap elections in April, expecting to increase the majority held by her Conservative Party and improve her leverage in Brexit negotiations. Instead, the party lost 12 seats and its majority in the June 8th vote, resulting in a hung Parliament. This uncertainty weighed heavily on the British pound, which fell 1.6% relative to the USD the following day. U.K. equities were more resilient, gaining 0.3% after the vote. Weakness in the pound served as a tailwind to larger, globally oriented U.K. companies, while some investors appeared to embrace the prospect of a softer Brexit. Later in the month, May formed a majority coalition after partnering with Ireland’s Democratic Unionist Party. The pound received a boost in the closing days of the month following hawkish comments by Bank of England Governor Mark Carney on June 28th. However, the potential for higher policy rates led to a modest sell-off in U.K. equities and the FTSE 100 Index was down 2.4% in local terms for the month. Just one day prior to Carney’s remarks, European Central Bank (ECB) President Mario Draghi also hinted at the prospect of stimulus withdrawal, which propelled the euro to a one-year high relative to the USD. That rally was quelled as the month came to a close as the ECB worked to clarify Draghi’s comments.
MSCI Adopts China A Shares
As part of its annual Market Classification Review, MSCI Inc., one of the world’s leading index providers, announced on June 20th that it would include China A shares in its broad equity indices. China A shares are stocks denominated in yuan and listed on mainland Shanghai or Shenzhen exchanges. China’s current index exposure consists primarily of Chinese companies that trade on foreign exchanges, such as Hong Kong and the U.S. Together, the Shanghai and Shenzhen markets account for over $7 trillion, making them the second largest equity markets in the world. The MSCI EM Index will include 222 large cap China A shares, accounting for approximately 0.7% of the benchmark. Implementation of the change will be conducted in two equal stages in 2018. The existing benchmark exposures will be reduced pro rata to accommodate A share exposure. China is already the largest country in the Index by a wide margin and is expected to exceed 29% once the changes are fully implemented.
MSCI’s decision to include domestic Chinese securities in its widely used EM equity index is a significant step in China’s efforts to open its markets to global investors and draw in foreign capital. MSCI’s three previous proposals to introduce A shares were rebuffed due to investor concerns regarding market transparency, corporate governance, accessibility, investor protections, government intervention, and repatriation. While MSCI has cited improvements on these fronts in China’s domestic market—most notably the introduction of the Stock Connect1—many of these concerns remain relevant and have led the index provider to take a cautious approach in its adoption of A shares. The 222 A shares are all large cap, accessible via the Stock Connect, and will be added at only 5% of their full market value. MSCI noted it would need to see continued market improvements and increased investor confidence before expanding the size and depth of A shares within its indices.